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Topic 5:Term structure of interest rates and international arbitrage Purpose:This lecture covers the yield curve, with international scope.

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Presentation on theme: "Topic 5:Term structure of interest rates and international arbitrage Purpose:This lecture covers the yield curve, with international scope."— Presentation transcript:

1 Topic 5:Term structure of interest rates and international arbitrage Purpose:This lecture covers the yield curve, with international scope

2 The DCF approach in general form: Given an efficient market, NPV is zero for a securities transaction Therefore, today’s price equals PV of all expected future cash flows

3 The DCF approach to coupon bonds: Computing price, with a known required rate of return: Computing yield-to- maturity –equals the rate implied by the market price –search by trial- and-error

4 Risk factors for bondholders: Purchasing power risk Interest rate risk Reinvestment risk Default risk

5 The yield curve: R = r + inflation adjustment + risk adjustment Inflation adjustment: R = r + i + ri r = (R–i)/(1+i) Three theories to explain the yield curve –Liquidity Premium Theory –Pure Expectations Theory (PET) also known as the Rational Expectations Theory easily remembered as the “Pet Rat” –Preferred Habitat Theory

6 Let's see how different theories explain what we observe: Upward sloping yield curve Flat yield curve Downward sloping yield curve R Maturity R R

7 McCauley’s Duration 0123 $300 $110$121$133.10

8 McCauley’s Duration: Cash flows discounted at 10% 0123 $300 $110$121$133.10 $100

9 McCauley’s Duration: Weighted average maturity 0123 $300 $110$121$133.10 $100 Duration = 100 300 1+ 100 300 2+ 100 300 3 ((())) Duration = 2

10 Living Yield Curve http://www.smartmoney.com/investing/bonds/the-living-yield-curve- 7923/?zone=intromessage

11

12 Convexity

13 Coupon Bias

14

15 Convexity


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